Stockwatch: Odds favour a takeover here

Are Poundland shares a decent speculation at 205p to 210p now that Steinhoff International Holdings has declared it may make an offer?

It appears another example of larger companies challenged to deliver financial progress in a low-growth environment, pouncing on those smaller - so bear this in mind as one element for stock-picking currently.

Steinhoff is a highly opportunistic acquirer, an odd beast in a 21st century generally obsessed with "focus", in pursuit of vertical integration. Its website proclaims "an integrated retailer that manufactures, sources and retails furniture, household goods and general merchandise in Europe, Australasia and Africa."

And there are firm reasons favouring a deal:

Progress to Europe's No 1 discount retailer

Latest prelims for the year to 27 March reflect the costs of integrating 99p Stores since last September's acquisition: total sales rose 18.7% to £1,326.0 million or by 9.3% to £1,214.8 million on an underlying basis, while pre-tax profits are down by 13.5% to £37.8 million underlying and by 83.7% to £5.9 million on a statutory basis.

Strategically, management asserts this increase in scale "has further strengthened our position as Europe's biggest single-price discounter" - likely the chief motivation for Steinhoff, which already owns Pep & Co, a chain of 50 UK discount clothing stores set up by former ASDA boss Andy Bond.

Against these uninspiring (as yet) operating results, Poundland has had to cut its total dividend by 19% to 3.65p, this payout covered about three times by underlying earnings. The balance sheet has deteriorated from £13.9 million net cash to £12.0 million net debt, partly because the cash flow statement shows net cash from operations down from £42.9 million to £4.4 million.

Portfolio investors can find yields of 5% and better, compared with 2% or so here, if it is at all secure. So Steinhoff has timed its approach well to achieve its strategic priorities: just when other shareholders are worried by a tough retail environment, with the stock already on a high price/earnings (PE) ratio and offering an unconvincing yield as compensation for the risks.

Steinhoff has dug itself in this time

These South African managers at Steinhoff appear to have steelier resolve compared with their approach for Home Retail Group last February where Sainsbury's got the upper hand. They have acquired a 22%-plus stake, partly via 15.3% sold by private equity group Warburg Pincus, reportedly at 195p a share.

Without a rival bid approach, such a stake cannot be traded on, in the short to medium term; hence Steinhoff is locked into at least an ownership role to help maximise the value of this stake, or a full bid sooner or later.

The likelihood of issues arising from a due diligence, to deter an offer, look small; Poundland's new CEO Kevin O'Byrne should have done this anyway and his response was to buy nearly £575,000 worth of stock, at 179p, last March.

If anything negative does come up it would more likely affect price than abort the approach: Steinhoff would not have dug itself in like this without resolve to follow through, or risk looking careless.

The new CEO would likely need compensating under his contract in a takeover scenario, partly for ceding listed company equity benefits, unless Steinhoff are able to offer him a satisfactory alternative.

But, more likely, the outcome in terms of price depends on what institutional shareholders will accept. Credit Suisse speculated on a 235p per share cash offer which, with 269 million shares issued, implies just shy of £650 million i.e. less than 0.5 times annual sales.

Yet even a new chief executive will likely be challenged to convince institutions of why the Poundland story should improve in the medium-term, given a tough consumer environment. Management says total group sales are up 30% in the 11 weeks to 12 June, but this includes the 99p Stores, whereas guidance is for a "challenging" first half year and a fall in like-for-like growth.

In such light, the 2017 consensus forecast (before these results and outlook statement) may be optimistic.

Potentially 30-40p upside, yet 50p downside risk

In raw terms, the risk/reward profile doesn't look much attractive, with the stock trading between 205p and 210p, compared with 150-155p before the Warburg Pincus sale and market speculation forcing admission of a bid approach.

Meanwhile, Poundland's figures and economic uncertainty - a 'Leave' result on 23 June would intensify this - imply Steinhoff in a commanding position to provide shareholders with an exit.

Unfortunately for Poundland management - if it prefers independence - the stock is already at a 37% premium to recent market price and, beyond the new chief executive's buying, there is no prop. Additional to the high PE and modest yield, goodwill/intangibles weigh on the balance sheet for negative net tangible assets.

Yet the market has likely been right to chase the stock, sensing Steinhoff's resolve. A 22%-plus stake implies strong motivation, therefore high chances of a deal, so it is correct that market price trades high in the upside/downside range of potential outcomes.

I drew attention in April at 175p, significantly due to the new CEO's buying and in context of an apparent "double bottom" chart pattern: a useful test of chart theory which implied an upwards reversal. That hasn't happened on fundamentals, but I did say cautious investors should await more evidence of them in June.

The 22% stake now looks the crux factor: Steinhoff is unlikely to be deterred by a Brexit vote, if wise to it potentially affecting shareholders' sentiment. So if you are put off by the extent of speculative rally then wait for the voting outcome next Friday.

Overall, it looks unlikely Poundland will stay independent and further premium for control be paid upward of current market prices, if Steinhoff respects the CEO's logic for buying at 179p.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.